So what's a decent investment opportunity? Lets take a look.
You get offered a superb two bedroom flat in what you consider to be a fantastic location. It's a two bedroom flat with luxury design interior, en-suite, balcony with a view, heated bathroom floor tiles, gym access, a concierge and garage parking.
The purchase price is £200,000 and you have a mortgage of £170,000 on a 85% LTV fixed rate mortgage of 5% paying interest only. This works out at £708.33 per month for the mortgage. The flat rents out for £825 per month. A healthy gross profit of £116.67 per calendar month. Perfect! Or is it?
There are many issues to consider here:
1. The Yield. The yield for this property is 4.95%. That is the rental return over a year that you receive versus the property purchase price (£9,900 / £200,000 x 100). I.e is it worth it? No. Why? It's all about minimising risk. As a good investor once said to me: “A good yield shows that rental demand must be strong”. A yield of over 7% is good and means that the property should always be worth at least 7% of its rental value to other investors.
2. Property Price. Lets face it, your buying into an area that is way above the national average house price of £184,924 (Source BBC News) where is the opportunity for decent long-term capital growth? Properties in regeneration areas offer a greater prospect for long-term growth.
3. Your Capital. £30,000 is the deposit you will have to put down on this fantastic flat. Let me tell you, that's a deposit for three flats/houses as far as I'm concerned! Any financial advisor or accountant will tell you to minimise your capital outlay in your investments. It's common sense. Why have one big property when you can have three smaller ones! The more properties in your portfolio the better the chance you stand at covering yourself during void periods with the profits of the others. Think about it! If you can’t fill this fantastic property for two months, you have wiped out your profit for the entire year!
4. Return On Investment. This is critical. Would you be better off putting the money in a savings account based on the return rate alone? This is the net profit over 12 months against the total investment cost. Let's assume that we don't have to pay for management and there is insurance at £20 per month for this property. That's £96.67 per month net profit (£116.67 gross profit - £20). Over 12 months that's a £1,160.04 return. Assume the investment costs were just the deposit and nothing else at £30,000 on a 85% LTV. The return on investment is 3.9% (£1,160.04 / £30,000 x 100). Shocking! The best savings accounts offer nearer 6% and don't start mentioning capital appreciation because that's why you need to read on!
5. Don't rely on capital appreciation. We always try to kid ourselves that it will be ok because it will be “worth twice as much in a year” this is no excuse to blind ourselves from making a bad investment decision. The combination of the above factors all clearly show that our investment example does not fully utilise our capital. We want to make sure that our money works as hard as possible for as little as possible.
6. Don’t buy with your heart. A classic but very good advice. If you went for the property in this example at the start you clearly were buying with your heart. The three simple factors to consider in any investment appraisal are (a) Ratios (b) Return (c) Risk. The three R's.
7. The Three R's.
For all investment appraisals you must calculate
(a) Ratios
(1) The Yield
(2) Return on Investment
(b) Return
Net Profit per month.
(c) Risk
Once you have calcualted the ratios and the return you must determine what risks are in place that will have an impact on you realising those financial goals. Remember, it's not all figures and paper. Some questions to consider are: Do you have a tenant in place? Has there been any payment issues? What are the Political, Environmental, Social factors of your investment? For example, are there any local council restrictions on development that would effect the re-sale? Is the property at risk of flooding? Is the property in a council housing area?
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